``Much has been written about panics and manias, much more than with the most outstretched intellect we are able to follow or conceive; but one thing is certain, that at particular times a great deal of stupid people have a great deal of stupid money.”-Walter Bagehot, English Journalist (1826-1877)
The markets appear to be headed in the direction which we have been anticipating albeit in a much gradual fashion. Yes, contrarians need the crowd to bolster their prescient views or investment positions.
Following the dynamics of the US markets, the Phisix breached its minor resistance levels to a high of 3,350 but closed back to within its new support levels/previous resistance. The Philippine benchmark ended the week up 1.95%, as the Peso continued to set new milestone 6 year highs at Php 47.46 against the US dollar.
While we are aware that the market action risk increases in an environment where momentum gets overheated, any present market declines in spite of the traditional seasonal weakness could possibly mean a pause rather than a reversal.
Taking a cue from Mr. David Kotok of Cumberland Advisors, ``We would now say to “sell in May” if the Fed Funds futures market was demonstrating an expectation that the Fed was going to hike in the future. This is currently not the case.” In other words, while Mr. Kotok expects the low interest rate environment as conducive for equity markets investing, we keep my fingers crossed.
The US dollar (trade weighted index) fell to near record levels as the Euro surpassed its December 2004 high ($1.3667) to set a fresh record at $1.3682. The euro closed at $1.3634 up .26% for the week.
As previously shown, we think that the falling US dollar has been the ONE major pillar which has lead to money flowing out of the “orthodox” US markets to the non-mainstream markets as the emerging markets or even timber (from Jeremy Grantham, Chairman of Grantham Mayo Van Otterloo).
A friend asked me recently on a choice whether to maintain his portfolio of US investments in the US equity markets or the Phisix. My obvious response was that it would be best to keep ourselves diversified. However, Figure 1 shows how the Phisix performed over the past three years as deflated by the US DOW JONES INDUSTRIAL Index.
Figure 1: stockcharts.com: The PHISIX vs. THE Dow Jones Industrials
The upper pane accounts for the movement of the US dollar trade weighted Index, while the lower pane represents the Morgan Stanley Capital Emerging Free Index. The center window shows how the Phisix performs relative to the Dow Jones Industrial Averages such that if the Phisix is outperforming the Dow Jones Industrial then the chart shows of a rising trend, and vise-versa.
The purpose of the US dollar is to once again show its PAST and PRESENT correlation with that of the Phisix, emerging market index and of the Phisix-Dow Jones activities.
Again, it is quite evident that over a longer period, particularly in 3 years (as the maximum coverage for FREE use), the Phisix has largely outperformed the US Dow Jones Industrials in an environment where the US dollar has been falling and vice versa.
Presently in spite of the weakening US dollar, the Phisix has consolidated and has not been at par with its previous performances, hence the red diagonal triangle at the rightmost edge.
Our question is: has the present underperformance been an outcome of “overvaluation” or an “exhaustion” from the previous run? Or will the Phisix eventually come up with a similar “lagged” rendition as shown in many instances in the past?
So before coming up with our answer let us look at the broader picture.
Heavyweight contrarian Jeremy Grantham, Chairman of Grantham Mayo Van Otterloo, thinks that world assets are in a bubble, where he says (emphasis mine)
``Never before have all emerging countries outperformed the U.S. in GDP growth over a 12-month period until now, and this when the U.S. has been doing well. Not a single country anywhere – emerging or developed – out of 42 listed by The Economist grew its GDP by less than Switzerland’s 2.2%! Amazingly uniform strength, and yet another sign of how globalized and correlated fundamentals have become, as well as the financial markets that reflect them.
``Bubbles, of course, are based on human behavior, and the mechanism is surprisingly simple: perfect conditions create very strong “animal spirits,” reflected statistically in a low risk premium. Widely available cheap credit offers investors the opportunity to act on their optimism. Sustained strong fundamentals and sustained easy credit go one better; they allow for continued reinforcement: the more leverage you take, the better you do; the better you do, the more leverage you take. A critical part of a bubble is the reinforcement you get for your very optimistic view from those around you. And of course, as often mentioned, this is helped along by the finance industry, broadly defined, that makes more money when optimism and activity are high. Hence they have every incentive to support rising markets as they do.”
While we agree with Mr. Grantham that some parts of the world have shown lathered or frothy conditions we do not subscribe to the idea that every asset class is a bubble yet.
Of course we could be speaking from a “conflict of interest-finance industry” point of view.
Relative to the Phisix, the degree of bubble exposure depends on how much credit money has been linked to the Global credit chain, which has buoyed the present state of the market.
In the same circumstances, we can hardly construe Japan’s equity market as being lifted by strong “animal spirits” to the same degree as in the US or some OECD countries. Japan has been experiencing a NET outflow due to residents looking for higher yields abroad.
Like us, Mr. Grantham raises the question of an imploding bubble as a question of timing. Mr. Grantham wrote, ``Of course the tricky bit, as always, is timing. Most bubbles, like internet stocks and Japanese land, go through an exponential phase before breaking, usually short in time but dramatic in extent. My colleagues suggest that this global bubble has not yet had this phase and perhaps they are right.”
Yet in the face of these bubble fears, we are seeing a radical trend shift of money flows towards non US markets, Alan Murray recently wrote in The Wall Street Journal (emphasize mine), ``We are witnessing a crucial moment in history -- the movement of U.S. capital markets abroad."
Tim Hansen of the Fool.com adds, ``Nine of the 10 largest IPOs of 2006 and 24 of the 25 largest IPOs of 2005 occurred in foreign markets.”
Deflationary “bust” advocates predict that a bubble implosion would result to a panic driven safehaven rush towards the US dollar and US treasuries, the premise being that the US as the most liquid and sophisticated market. Yet present day evidences have proven otherwise, as shown in Figure 2.
Figure 2: World Federation of Exchanges: World Equity Markets Overtake the US
Since global markets have bottomed out in 2002, the share of US markets relative to world markets in the context of market capitalization has shrunk from 52% to 45% in 2006. This is because Asia has generated the best returns up 168% over the same period compared to Europe’s and MENA (Middle East and North Africa’s) 140% and the Americas at 90%.
And as we have previously pointed out, this dollar “decoupling trend” has not been limited to the equities market but also to bond markets where the Euro has displaced the US dollar for the second year in succession, or to Euro notes in circulation exceeding that of the US dollar or to the falling share of the US dollar as foreign exchange reserves, but retaining the majority, in the global banking system.
In addition, with the emergence of “Sovereign Wealth Funds” [SWF] or countries with foreign exchange reserves surpluses which assigns a separate national entity or public “fund” to manage or invest excess reserves, the likelihood is that these trends will be further accentuated.
Remember, in the recent past, excess reverses by Asian countries or Oil Exporting states have been recycled into US assets. Today, the thrust to diversify from the US dollar assets appears to be taking place via the medium of SWF into the global financial markets.
How much funds are we talking about? An estimate by Morgan Stanley’s Stephen Jen is that 24 of these funds hold some $2.3 trillion or about 5% of 2006 market cap with growth of about $500 billion a year! Now with public financial “funds” beginning to compete with private funds for returns, yields are going to be more marginalized than ever although risky assets could be more supported as liquidity flourishes.
However, could the financial instability side today emanate instead from the fundamentally altered world financial risk profile as Mr. Stephen Jen recently suggests? Perhaps. Apparently we are witnessing the emergence of new financial paradigms or evolutions in the financial system at work, although like the innovative financial products, these have not been stress tested and could be sources for volatility (such as politically induced ones). And that new paradigms or “different this time” axioms give us jitters.
Present developments tell us that in spite of the present lethargic economic state (real GDP of the US grew below market expectations of 1.3% on high GDP price index) US financial markets appear to be experiencing a prolonged bonanza (DJIA up 1.23% for the fourth consecutive week). However, as exhibited above the gist of the benefits has been moving away from US assets and into global markets.
Could such developments underscore the unintended consequences from the highly taxing Sarbanes-Oxley Act? Or could the US dollar’s woes have prompted for the exacerbation of such trend of outflows? I think more of the latter is the culprit.
For me, Mr. Doug Noland of the Credit Bubble Bulletin, has got the best answer among the analysts I monitor (emphasis mine), ``U.S. securities markets continue to lag much of the rest of the world. Yet there is an ingrained market perception that financial tumult/crisis is invariably instigated at The Periphery. Participants have been conditioned to believe that risks and excesses are greatest with the inherently fragile “emerging” markets. These markets have also tended in the past to perform as credible “canaries in the mineshaft,” warning of more generalized financial turbulence. So with emerging markets again trading well and crude and commodities on the rise, complacency with respect to the general liquidity backdrop has returned with a vengeance.
``Here’s where the markets could have it gravely wrong: the greatest vulnerabilities associated with the most egregious (ongoing) excesses today reside not at The Periphery but at The Core. Indeed, current global liquidity excesses are now exacerbated by heightened excesses and flows away from The Core, in the process masking heightened securities market fragility throughout The Core.”
Put differently, if the credit excesses have been due to the US (The Core) why would a bubble implosion or a panic driven run lead money back (from where it originated) and not towards the Periphery (global markets)? Could today’s developments instead serve as an initial manifestation of a deepening trend in preparation for such “tailed event”?
Further if capital outflows would translate to higher interest rates in the US, does it suggest that higher rates could stanch such exodus?
Mr. Axel Merk of Merk Investments debunks such myths (emphasis mine), ``It seems that ever since academics developed a theory of how interest rate differentials move currencies, the theory has not worked. Yet just about every textbook continues to teach it. Aside from the fact that expectations on future interest rates and inflation are more relevant than actual interest rates, there are simply too many factors influencing currencies to be able to focus in on interest rates. Why do some low yielding currencies, such as the Swiss franc, perform reasonably well, whereas many developing countries have weak currencies despite high interest rates?
``A good year ago, the U.S. joined the ranks of developing nations in paying more in interest to overseas creditors than it receives in interest from its own investments. As a result, higher U.S. interest rates mean higher payments abroad, further weakening the foundations of the U.S. dollar.”
So aside from speaking from the perspective of a “home biased” investor, our analysis leads us to think that risks for more declines in the US dollar could exacerbate outflows from US capital markets into the world. This perhaps validates why our 90 day treasuries have been lower than that of the US counterparts.
Given the above premise, I guess the “appropriate” suggestion for my friend would be to give weight more into Asian assets or to the Phisix than that of its US contemporaries.
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